Explicit Costs vs Implicit Costs
Explicit Costs and Implicit Costs are two Production & Costs concepts in AP Economics that students often mix up. Explicit Costs are direct, out-of-pocket payments made by a firm for inputs purchased from others. Implicit Costs are non-monetary opportunity costs of using the firm’s own resources. Here is how they compare side by side.
These include wages, rent, and raw material expenses that involve actual cash transactions and are recorded in accounting records. They are part of both accounting and economic profit calculations.
These include the foregone salary of the owner working in the business or the rent that could have been earned by leasing owned property. Implicit costs are included in economic profit but not in accounting profit.
Explicit vs Implicit Costs: What Leaves the Bank Account
| Explicit costs | Implicit costs | |
|---|---|---|
| Involves a payment | Yes, money changes hands | No, nothing is paid to anyone |
| Appears in the accounts | Yes | No |
| Examples | Wages, rent paid, materials, utilities, interest on a loan | The owner's forgone salary, interest forgone on the owner's own capital, rent forgone on a building the owner occupies |
| Also called | Out-of-pocket or accounting costs | Opportunity costs of owner-supplied resources |
| Used in accounting profit | Yes | No |
| Used in economic profit | Yes | Yes |
The test is whether anyone got paid
An explicit cost involves a payment to someone outside the firm. If money left the account, it is explicit. An implicit cost is the value of something the owner already owned and chose to use in the business, so no payment was made but an alternative was given up. Ask a single question about every item in a scenario: did the firm pay anyone for this? Rent on a leased shop is explicit. The rent the owner could have charged on a shop they own is implicit. A hired manager's salary is explicit. The salary the owner gave up to manage it themselves is implicit. Both are real costs to an economist, because both represent resources that could have been used elsewhere.
Implicit costs are the reason economic profit exists
Economics treats cost as opportunity cost, the value of the best alternative given up. That definition does not care whether a payment happened. If you use a resource here, it cannot be used there, and the value of the there is a cost of the here. Accounting cannot work this way, because it records transactions and there is no transaction to record when an owner uses their own building. So accounting profit subtracts explicit costs alone, and economic profit subtracts both, and the difference between the two figures is exactly the implicit costs. See /glossary/compare/accounting-profit-vs-economic-profit for how the two profit measures follow from this.
The traps that appear in exam scenarios
Three items catch students out. First, a sunk cost already spent is not a cost of continuing, First, a sunk cost already spent is not a cost of continuing, so the money spent on equipment last year does not belong in this year's decision. What does belong is the resale or rental value the equipment gives up by being used this year, which is an implicit cost, not the depreciation line in the accounts, which is only last year's spending spread over time.. Second, an owner who could earn a salary elsewhere has an implicit cost even if they enjoy the work more; personal satisfaction is a benefit, not a reduction in cost. Third, capital the owner invested has an implicit cost equal to the return it would have earned elsewhere, so 100,000 dollars of own money in a business that could have earned 5 percent in bonds carries a 5,000 dollar implicit cost per year. Scenarios usually plant exactly one implicit cost in a list of explicit ones, so read for the phrase gave up, could have earned, or previously worked as.
Frequently asked questions
What is the difference between explicit and implicit costs?
Explicit costs involve an actual payment to someone outside the firm, such as wages, rent, or materials, and they appear in the accounts. Implicit costs are the value of resources the owner already owns and uses in the business, such as a forgone salary, and no money changes hands. Both are real costs to an economist.
Is the owner's forgone salary an explicit or implicit cost?
It is an implicit cost. Nobody is paid it, so it never appears in the accounts, but it is the value of the owner's best alternative use of their own time. It is subtracted when calculating economic profit and ignored when calculating accounting profit.
Are implicit costs real costs?
Yes. Economics defines cost as opportunity cost, the value of the best alternative given up, which does not require a payment. A resource used in the business cannot be used elsewhere, and the value of that forgone use is a genuine cost of operating even though no transaction records it.
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